While not a New York case, a recent divorce case in Delaware Family Court sheds new light on an old precedent for the treatment of enterprise goodwill in a sole proprietorship.
The couple in A.A. v. B.A. married in 1979 and divorced in February 2017, but the case lingered, with a decision regarding the valuation of the husband’s financial advisory practice, a sole proprietorship, coming in October 2020.
Both spouses hired experts to value the business. The experts reached widely divergent conclusions, with the husband’s expert valuing the business at $255,000, while the wife’s arrived at a value of $3,488,0000 to $3,500,000.
The court rejected the report by the husband’s expert, taking issue with both its failure to consider the business’s goodwill and its reliance on a flawed asset approach.
“From the outset, husband’s expert’s opinion was limited by his belief that Delaware law was settled that there could not be good will in a sole proprietorship,” reads the decision.
The husband’s expert had relied on a 1983 Delaware Supreme Court decision. In E.E.C. v. E.J.C., (457 A. 2d 688, Del. 1982), the court had rejected the consideration of goodwill in the valuation of a sole practitioner’s law practice. According to the decision in A.A. v. B.A., the husband’s expert took that oft-cited decision as an indication that Delaware case law does not permit the use of goodwill in valuing sole proprietorships under any circumstances.
The court rejected this premise: “The court notes that husband’s business in the present case is not a law firm and the practice and means of generating income are different. The court does not read E.E.C. as stating every sole proprietorship in every case has no professional good will.”
The court agreed with the wife’s expert, who assigned 5 percent of the total goodwill to the husband based on the value of his noncompete agreement, and the remaining 95 percent to the business. The court said both experts agreed that, if the husband could transfer goodwill such that he could transfer to a buyer his client base and stream of income, or even 95 percent of his stream of income, he could receive about $3.5 million for the business.
Misassessed assets
The court also took issue with the husband’s expert’s asset approach, which did not consider income earned but not yet paid to the business as of the separation: “Husband continued to run the business and the value receive[d] by husband through receivables, work in process or residual commission tails was well beyond the amount placed on it by husband’s expert. This would probably explain why the husband himself placed a value of $10 million on the business in his financial statements.”
The decision notes that, between the date of separation and late 2019, the husband extracted more than $4 million from the business, including commissions for work done during the marriage. This included a $600,000 commission received in 2018 that had been in the making for perhaps three years, according to the husband’s testimony.
The wife’s expert used a weighted combination of the income approach (capitalized income method) and market approach (transaction and guideline public company methods). The court relied on the wife’s expert, determining that the business’s value was $3,488,000.
The case is A.A. v. B.A., CN16-05018 (Del. Fam. Oct. 9, 2020). Read the decision here.
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